Heritage Financial Corporation

Hello everyone and welcome to today's call. My name is Drew and I'll be your conference operator today. At this time, I would like to welcome everyone to the Heritage Financial Q4 and year-end earnings call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. To ask a question, please press start followed by one on your telephone keypad. If you change your mind, please press start followed by two to withdraw the question. I will now turn the call over to your host, Jeff Dewell, CEO. Please go ahead.

Thank you, Drew. Welcome to everybody who called in and those who may listen later. This is Jeff Dewell, CEO of Heritage Financial. Attending with me are Brian McDonald, President and Chief Operating Officer, Don Henson, Chief Financial Officer, and Tony Chalfant, Chief Credit Officer. Our fourth quarter earnings release went out this morning pre-market, and hopefully you have had the opportunity to review it prior to the call. We have also posted an updated fourth quarter investor presentation on the investor relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity, and credit quality. We will reference the presentation during the call. Please refer to the forward-looking statements in the press release. We are reporting a somewhat noisy quarter that ultimately sets us up well for 2024 and beyond. That so-called noise can be attributed to active balance sheet management and expense reduction measures. When we started to run the preliminary budget for 2024, non-interest expense was running around $171 million for the year. That, coupled with continued pressure on margins, caused the management team to take a hard look at our org structure in Q4, and we were able to get that number down to a run rate more around 162 million. In the end, expense reduction actions included contract rationalization, elimination of management layers, streamlining certain back office operations, and exiting our retail mortgage platform. all of which will be referenced in this presentation. We continue to see pressure on deposit pricing in Q4, and we expect to see this continue for the near term. Deposit balances declined modestly in Q4, and the mix of deposits continues to partially shift to higher rate products. Loan growth was strong in Q4, running at a 7% annualized rate. Credit quality remains strong, resulting from our long-term practice of actively managing the loan portfolio. We have ample liquidity, a low loan-to-deposit ratio, and a solid capital base. Going forward, we will keep a sharp eye on expenses while we focus on growing loans and deposits. We'll now move on to Don Henson, who will take a few minutes to cover our financial results.

Thank you, Jeff. I will be reviewing some of the main drivers of our performance for Q4. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the third quarter of 2023. I want to start by covering some actions that significantly impacted earnings for Q4 and are expected to improve earnings in future periods. First, we repositioned a portion of our investment portfolio, which resulted in a pre-tax loss of $10 million during the quarter. We sold 152 million of securities with a weighted average yield of 2.41% and purchased 141 million of securities yielding 6.08%. Including the yield and cash not yet reinvested at year end, we are expecting an annualized interest income pickup of about $5 million from these transactions, resulting in an earn back period of approximately two years. Second, we incurred certain costs related to expense management measures in order to lower expenses in future periods. These included $1.5 million in contract negotiation fees, which will lower costs of the related contract over a six-year period, $320,000 due to the write-off of a contract that we will not be replacing, and $148,000 of severance payments to terminated employees. As mentioned in the earnings release, these costs, in addition to approximately $1.2 million of severance payments expected to be incurred in Q1, will result in annualized cost savings of approximately $5.3 million. These and other expense management measures are being taken to improve our performance in 2024 and beyond. Please see page 6 of the investor presentation for more information on these actions. Moving on to the balance sheet, loan growth was strong in Q4, increasing $69 million for the quarter. For the year, loan growth was $285 million, or 7%. Yields in the loan portfolio were 5%. for the quarter, which was five basis points higher than Q3. Brian McDonald will have an update on loan production and yields in a few minutes. Total deposits decreased $35 million during the quarter. The decrease was due to a decrease of almost $100 million in non-maturity deposits, partially offset by an increase of $64 million in CD balances. Customers continue to take advantage of the higher rate environment by lowering their excess balances in lower-paying non-maturity deposit accounts. These factors contributed to an increase of 25 basis points in our cost of interest-bearing deposits to 1.48% for Q4. Due to the current market pressure related to deposit rates, we expect to continue to experience an increase in the cost of our core deposits. This is illustrated by the cost of interest-bearing deposits being 1.56% for the month of December with a spot rate of 1.59% as of December 31. Investment balances decreased $21 million during Q4, partially due to the lost trade previously discussed. The security trades occurred from mid-November to mid-December. Therefore, the benefit of lost trade was not fully realized in Q4. Even without full realization of the lost trade benefit, the yield in the securities portfolio increased 16 basis points from the prior quarter to 3.15% for Q4. Moving on to the income statement, net interest income decreased $1.7 million from the prior quarter due to a decrease in the net interest margin and in average earning assets. The NIM decreased to 3.41% for Q4 from 3.47% in the prior quarter. The decrease in NIM was primarily due to the cost of interest-bearing deposits increasing more rapidly than yields on earning assets. We expect NIM to decrease further in Q1 2024 since NIM for the month of December was four basis points lower than it was for the entire quarter, Q4. The pace and duration of our decrease in margin will be highly dependent on continued increases in our cost of in-spring deposits as well as maintaining deposit balances. Our cost of deposits as well as deposit balances, as they level off, we expect to experience margin stabilization due to the repricing of adjustable rate loans in addition to higher origination rates on new loans. In addition, current rates on broker CDs are lower than those currently on our books, which will help mitigate other deposit cost pressures as these roll over. We recognize the provision for credit losses in the amount of $1.4 million during the quarter. The provision expense was due to a combination of loan growth and net charge off of $618,000 recognized during the quarter. Removing the impact of significant Q4 expense items previously mentioned, non-interest expense decreased from the prior quarter due partly to lower FTE levels. Average FTE was 803 for Q4 compared to 821 for Q3. These levels will decrease further in Q1 2024 and are expected to decrease to less than 780 by Q2. All impacted employees have already been notified. Due to the previously mentioned severance costs in Q1, Q1 non-interest expense levels are expected to be somewhat elevated from the go-forward run rate. Beginning in Q2, we expect the expense run rate to be between 40 and 41 million. All the regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio increased to 8.8% at year-end from 8.2% at the end of the prior quarter. This increase was due substantially to improvement in our AOCI as market rates improved the overall fair value of our securities portfolio. I will now pass the call to Tony, who will have an update on our credit quality metrics.